Britain will not escape from the China and commodity death loop

People riding a rollercoaster.Wikimedia Commons
What happens in China doesn't necessarily stay in China. Britain's fortunes have been linked to the global economy for centuries and 2015 is no different.

The picture is not rosy out there. Commodities are in the midst of one of most severe price crashes outside of a global economic crisis, while China is balancing a stock market collapse against a shift in policy away from production to consumption and may miss its 7% growth target.

The two are linked in a loop.

As Chinese growth weakens, the country's manufacturing sector slows down and needs fewer raw materials. As demand for commodities falls, so does the price, hurting economies such as Australia that depend on exporting them. This leads back to less demand for China-made goods.

The UK economy, being outward looking for a lot of its goods, isn't out of this loop.

In case you missed it, this is what a 12 month bloodbath in commodities looks like:

Macquarie

Britain's economy is actually doing relatively well at the moment.

It's going through the third-longest spurt of economic growth since 1955, with UK GDP up by 0.7% between April and June, compared to the three months before. And although the quick uptick in employment recorded has faded a little, it's being replaced by growth in wages.

But this recovery is still fragile.

UK industrial production declined 0.4% in June, surprising analysts who predicted a 0.1% increase. It was led lower by mining and quarrying, which fell a huge 3.8% month-on-month, according to the Office of National Statistics, as the commodities price rout worsened.

The toxic mix is also one of the reasons why the Bank of England is struggling to raise interest rates.

The BoE can't get inflation going with loose monetary policy when prices are falling with commodities. Meanwhile a rise in rates would also strengthen the pound, hurting exports where demand is already weakening.

Here's the pound vs the euro from Bloomberg:

Bloomberg

The Bank of England saw a lot of this coming back in February when it announced its nightmare scenario to test UK banks' capital strength in this year's stress tests. The BoE does annual health checks on banks to make sure they can weather extreme but hypothetical economic crises without collapsing. If they fail, they have to raise capital and take fewer risks.

The round of tests this year focuses on the China/commodities death loop, and helps explain how it might hit the UK economy.

The adverse scenario the BoE put in place for the bank exam has China in total decline, growing only 1.7% in Q4 2015.

This pushes down China's trading partners and commodities, at which point "the global downturn impacts the United Kingdom. Output growth turns negative as export demand falls sharply. There are additional spillovers, through financial linkages and confidence effects."

It's good news the BoE is prepared for the worst, but it's perhaps a bit too close to reality for comfort.